Super Mario and the Australian bulls

The latest European agreement is likely to drive a stock market revival, but when the Germans realise Angela Merkel was out-negotiated by Mario Monti, extracting money for the next bailout could prove challenging.

In the weekend European settlement there are all the ingredients required for a major international stock market revival so don’t be surprised if higher share prices continue for the next month or two.

But the ingredients for an end to that revival are also there and can be summarised in a few words – low non-German productivity cannot sustain the common currency and the Greek situation will underline this.

So this morning’s task is to look at why markets appear likely to be boosted by the agreement and then look longer term at what can go wrong. As always, predicting the reaction of markets to events is hazardous, but I call it as I see it.

In essence after years of kicking the can of European problems down the street and doing nothing effective there became only two broad ways for Europe to go – first was to use the German savings and wealth to bail out the southern European states. This first course would be very bullish for stock markets but, understandably, was something Germans did not want to do. The second course was to split the euro, which would cause enormous damage to the European and world banking systems. Stock markets would fall dramatically.

At the European Summit Germany took a big step towards committing another big chunk of their funds towards saving Southern Europe. And they directed the rescue towards what had always been a key problem – most of Europe’s banks have no capital. Until now the political leaders concentrated on government debt and had virtually ignored the banking problem. Yet as major mobilisers of Middle Eastern funds the European banks had a key role in word trade and global inter bank deals. If the European banks failed the repercussions would be wide spread and this has been a major force holding stock markets back.

There are enormous sums of nervous money on the sidelines waiting to go back into the share market and despite the big international share price rises over the weekend there are still significant short positions in the international markets. Liquidity is strong and all that is required is a few bullish events to cause a rush of money into shares, which will force shorters to cover and go long which doubles the impact.

As well as the European agreement, the US housing market has bottomed (A ray of hope for US housing, June 29), and China is once again stimulating so we have a very powerful set of ingredients capable of sustaining a stock market rally.

Over the last year or two we have had a succession of these one, two or three month rallies only to see them run out of steam.

The forces are lined up for another such rally but as previous rallies have burned capital it is always possible people will be much more wary this time. But institutional traders are gamblers and gain their rewards by short term punting. They have no long-term memory.

Let’s look at some of the basics elements behind the European agreement.

We first must recognise that this is not what German Chancellor Angela Merkel had in mind. But in the all night sessions she encountered one of the must skilled negotiators in Europe, Italy’s non-elected Prime Minister Mario Monti

This man was not a politician but few people know more about the weakness and strengths of Europe. Merkel has rarely had to deal at close quarters with a non-British European political leader who she could not wrap around her finger. And Monti could operate with small amounts of sleep and understood that unless Spanish and Italian banks were saved German banks would be decimated causing widespread damage to the German economy. A Greek collapse would bring on this German crisis unless there was a pre-emptive strike to help Spanish and later Italian banks. Accordingly, he could scare Merkel. Like all deals done when the parties are tired, this European settlement is full of holes but in coming weeks Monti will make sure many of these holes are filled.

But as the months roll on the Germans will come to understand what their sleep deprived leader agreed to under pressure from someone as brilliant as Monti. Another chunk of their wealth has gone to rescue Southern Europe, possibly including Greece, although Greece could be isolated.

Unlike most other European leaders Monti understands that if an industrial nation like Italy is to have a common currency with Germany then it must be far more productive.

So prior to the summit one of his first steps was to make it easier to hire and fire Italian workers. He could not go as far as he wanted to but it was an important first step (and of course Australia is moving the other way by making it harder to fire. We need a Monti).

Monti understands that a whole range of actions are required to lift Italian productivity. And the same applies to Spain. But essential to that process is the need to have a solvent banking system so that productive enterprises can get loan capital.

Italy’s former Prime Minister Silvio Berlusconi believes that Italy cannot match Germany in productivity and wants Italy to leave the euro. I believe that as the months roll on, the euro break up pressure will re-emerge, particularly given the holes in the agreement which does detail how the bank recapitalisations will take place and exactly what controls will be put in place, including the level of German control exercises via Brussels. The Germans will feel betrayed if they discover that Angela Merkel was out-negotiated, which will make it harder to extract the next tranche of German money.